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Understanding financial statements

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Last updated on June 17, 2014

Financial statements provide information on how the business is operating financially and why. Ensuring financial statements are produced regularly will provide information for continual improvement of business operations.

Profit-and-loss statement

The profit-and-loss statement (also called an income statement) is a summary of a business's income and expenses over a period of time. It is prepared at regular intervals (usually monthly and at the end of the financial year) to show the results of operations for a given period.

It's a good idea to do a monthly profit-and-loss statement and analyse all income and expense categories. By doing it regularly, you'll quickly get a good understanding of your income and costs. You'll see the areas that need more analysis, and be able to take action before small problems become big problems (for example, if business expenses are increasing you may need to re-price your goods to continue making a profit).

Balance Sheet

The balance sheet is a general snapshot of the financial health of a business on a given day, usually the end of a month or financial year.

Note: a profit-and-loss statement and cash-flow statement (see below) are needed to do a balance sheet. Your accountant is probably the best person to prepare a balance sheet. Accounting packages also offer balance sheet reports.

Your balance sheet lists in detail the assets that the business owns, and what it owes to others (its liabilities). The difference between the assets and liabilities is the net worth of the business. The net worth (also called the 'ownership equity') shows how much the business is worth to the owner or owners on the day the balance sheet was prepared.

Balance sheets feature the following elements.

Assets are the items of value the business owns. They include:

  • cash and stock on hand ('inventory')
  • land and buildings
  • equipment and machinery
  • furniture
  • patents and trade marks
  • money others owe the business ('debtors' or 'accounts receivable').

Liabilities are what the business owes others outside the business. They include:

  • money owed to suppliers
  • money owed to taxation department (such as GST, PAYE or FBT)
  • bank accounts that are in overdraft (meaning you owe the bank money) and/or credit card debt
  • loans to buy capital assets, such as a new vehicle.

Ownership equity or net worth is a figure that shows the value of the business after deducting what the business owes from what it owns, on the day the balance sheet is prepared. A negative figure means the business has debts it cannot pay.

Balance sheeet classifications assist with monitoring the financial position of your business.  These classifications are referred to as 'current' and 'non-current'.

Current refers to a period of less than 12 months and non-current is any period greater than 12 months. Current assets will include items that are likely to be turned into cash within a twelve month period such as cash in the bank, monies owed from customers (referred to as debtors) and stock.

Non-current assets are shown next on the balance sheet.  These are assets that will continue to exist in their current form for more than 12 months. These can include furniture and fittings, office equipment, company vehicles and more.

Current liabilities are all those monies that must be repaid within 12 months and would typically include bank overdrafts, credit card debt and monies owed to suppliers.

Non-current liabilities are all the loans from external stakeholders that do not have to be repaid within the next 12 months. 

The balance-sheet equation is the value of all the business's assets, less the value owed to those outside the business (liabilities). This figure equals what the business owner or owners can say the business is worth, or its equity (for example assets ($73 000) less liabilities ($28 500) equals equity ($44 500).

Equity is also referred to as 'net worth', as the amount represents the net worth of the owner.

Cash-flow statement

A cash-flow statement is a summary of money coming into and going out of the business for a set time period. It is prepared regularly (monthly and at the end of the financial year) to show where cash is coming from and what it is spent on.

The cash-flow statement can be a useful tool to measure the financial health of a business and can provide helpful warning signals. Three potential warning signs which, in combination, can indicate the potential for a business to fail are:

  • if your cash receipts are less than cash payments, you are running out of money
  • if net operating cash flow is an outflow, your cash flow is negative
  • if net operating cash flow is less than profit after tax, you are spending more than you earn.

Note: Net operating cash flow is the amount of cash that a company gets to keep for running its business after it has paid its bills. However, even if a business has a number of overdue bills, these do not affect the cash-flow statement until they are paid in cash.

The cash-flow in and out of the business is divided into three categories in the cash flow statement.

Operating activities are day-to-day activities, the result of buying and selling goods and services. They usually include:

  • receipts from income
  • payment for expenses and employees
  • funding of debtors
  • funding to and from suppliers
  • stock movements.

Investing activities in future business such as buying and selling fixed assets. These can include items such as:

  • payment for purchase of plant, equipment and property
  • proceeds from selling the above
  • payment for a new investment
  • proceeds from selling an investment.

Financing activities cover how a business finances itself. Examples include:

  • extra money the owners inject into the business
  • money the business borrows
  • money others borrowed from the business they pay back
  • money the owners take out of the business.

Equity is also referred to as 'net worth', as the amount represents the net worth of the owner.

Other financial statements

The financial statements discussed above provide information on the historical financial information of your business. In addition, a cash-flow forecast will help you measure and monitor how the business is operating against what you were expecting.

(This information has been reproduced from Business Victoria www.business.vic.gov.au)

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